A loan taken out to finance the day-to-day activities of a business is called working capital loan. These loans cannot be used to buy long term assets or investments. Instead, they provide the working capital that meets the short-term operational needs of the business. It is safe to say that working capital loans are simply business debts that are used to fund the day to day operations of a business.
How Does a Working Capital Loan Work?
When a company does not have sufficient liquid assets or liquidity to cover its daily operating expenses, it opts for a loan for this purpose. Businesses that have high seasonality often rely on working capital loans.
Many businesses do not have a stable income throughout the year. For example, manufacturing companies have cyclical sales that match the demands of retailers. Manufacturers with this type of seasonal work often need a working capital loan to pay salaries and other operating expenses. By the time the business reaches its peak season and no longer needs financing, the loan is usually paid off.
Working capital loan: definition and eligibility criteria
Methods to improve working capital
Banks are authorized by the Central Bank to generate their lending method for working capital loans in India. But the methods of third party lenders are relatively flexible for the best working capital loans. The turnover method is generally used by banks to check working capital limits.
The maximum allowable bank funding or cash budget method is the age-old method of assessing working capital limits, which depends on the needs of the client.
The limit for each facility according to the MPBF (Maximum Permissible Bank Finance) method will depend on the nature of the current. From time to time working capital standards are prescribed for lenders.
A study group, which was led by Shri. PL Tandon, framed guidelines for quick working capital loans in July 1974. These recommendations are known as the Tandon Committee recommendations. Of the three methods proposed by the Tandon Committee, method I and method II were retained for the assessment of working capital limits, which are explained below.
Tandon’s first method
According to Tandon’s “first method” of the loan, the borrower must have 25% of the Working Capital Gap (WCG) as a margin.
The following illustration can explain the ‘first method’ –
Take the example of a company whose total current assets (TCA) is Rs. 1,000 and other current liabilities (OCL), that is to say (without the working capital facilities of the bank) is Rs. 200. We will now calculate the maximum authorized bank financing (MPBF) according to method I.
TCA = 1000 and OCL = 200,
WCG is (TCA-OCL)) = 1000 – 200 = 800 —————————— Let’s call it as (A)
25% of WCG = 800 × 25 100 = 200 ———————— Let’s call it like (B)
(i.e. Minimum net working capital)
In this case, Maximum authorized bank financing (MPBF) = (A) – (B) = 800-200 = 600
Therefore, the bank’s MPBF under the first method is Rs. 600 if the total current assets are Rs. 1000
Current ratio in the first method: Given that the total current liabilities (including bank financing) would be Rs.800 compared to the total current assets of Rs.1000, the minimum current ratio under the I-method would be 1000: 800, that is, that is, the minimum current ratio is 1.25: 1.
This method is also called “second method”). In this method of lending, the borrower must have 25% of total current assets (TCA) as a margin.
Drawing: Let’s take an example where the TCA of a company is Rs.1000 and OCL is Rs.200. We are now going to calculate the MPBF according to the 2nd method.
WCG = CA – CL = 1000 – 200 = 800 ———————————————— Let’s call it as (x)
25% TCA = 1000 × 25 100 = 250 ——————————————– Let’s call it as (y)
The MBPF according to the second method is (x) – (y) = 800 – 250 = 550
MPBF, from the Bank according to the second method, is Rs. 550 when the total current assets is Rs. 1000 and the working capital gap is Rs. 800.
Current ratio in the second method: Given that the total current liabilities would be (200 + 550) = 750 compared to the total current assets of Rs. 1000, the minimum current ratio under method II would be 1.33: 1.
The drudgery committee which was appointed in April 1979 suggested that all borrowers, except sick units which have a working capital of Rs.50 lakhs and more from the banking system, be positioned according to method II which will give a current ratio of 1.33: 1..
In accordance with RBI guidelines, the lower limit of Method II is changed from time to time, but the current benchmark ratio of 1.33: 1 is expected to remain unchanged.
Working Capital Loans And Why Is It The Best Financing Option?
Cash budget method
Industries dealing with seasonal products like sugar and tea, construction activities, film industries, order-based activities, etc. follow the outline of the maximum cash deficit. The need for financing may be greatest during certain calendar months in the aforementioned industries, while the realization of the proceeds of the sale occurs in the future.
Therefore, under this method, bank financing is approved on the basis of the monthly forecast cash flows estimated by the borrower and accepted by the lender. Some lenders consider a lower ratio on a case-by-case basis depending on the quality of current assets and components and current liabilities.
Important points to note in valuing working capital
- When evaluating financial statements, lenders consider whether the borrower is able to achieve the projection that he has made.
- Lenders also look at the following factors for future production and sales.
- Production / sales trends in the past,
- The number of production capacities available,
- Accessibility of labor, power, raw materials, etc.
- The competitive strength of the borrower,
- Development, research and renovation,
- Economic factors such as import restrictions, product demand, etc.
- The profitability ratios are arrived at to compare with the past trend and similar unit types in the same company. Profit ratios help lenders assess the company’s ability to profit from sales, return on equity,Return on Total Assets, Accounts Receivable Revenue and test of management’s pricing policy against others in the company.
- It is essential that the use of limits be appropriately mimicked by transactions and inventory statements before taking projection limits into the account. It is important that the debits / credits turnover in the balance sheet corresponds to the full year of the balance sheet.
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